How to Spot Market Tops: Interest Rate Spreads

Over the past several days, we discussed 4 ways to identify market tops: macroeconomic indicators, interest rate raising cycles, valuation metrics and market sentiment. Here, on the 5th and last part of this series, we will analyse interest rate spreads and see what they tell us about the current market.

1. High Yield Spreads

Rapidly rising interest rate spreads between corporate bonds (high yield) and US Treasury bonds are often an indicator that economic conditions may be about to turn. They could also indicate that the stock market may be about to peak. When investors anticipate that economic conditions will deteriorate, they switch from higher-risk corporate bonds into safe US government debt. This increases corporate bond yields and decreases US treasury yields, widening the spread between the two.

As we can see from the chart below, the last two recessions were preceded by a persistent rise in high yield spreads.

Source: Federal Reserve Bank of St. Louis

Today, however, these spreads are still close to historical lows, which indicates that we might be still some time away from a market top. In fact, if we compare the current spreads with equivalent periods in the past, we see that spreads were lower only about 34% of the time. Therefore, we should expect high yield spreads to start increasing soon, which should give the current bull market further room to run.

Source: Guggenheim High-Yield and Bank Loan Outlook April 2017

2. Loan Spreads and Default Rates

Another way to look at the current cycle is to consider the spread between bank loans to individuals and corporations, and the rate at which banks lend to each other (LIBOR). In general, increasing spreads suggest higher risk in the economy. At the moment, loan spreads are tightening, and default rates are low, once again indicating that it is not yet time to be running for the exits.

US loan spread over LIBOR
Source: UBS High yield bonds , April 2017

US loan default rate

Source: UBS High yield bonds , April 2017

3. Yield Curve

Finally, another very important way to detect market tops is the spread between long-term and short-term US treasury yields. According to Charlie Bilello of Pension Partners, the past 9 US recessions were all predicted by yield curve inversion (defined by a negative spread between long-term and short-term yields). The average lead time was 14 months.

Source: Federal Reserve Bank of St. Louis

More significantly, in the past 9 recessions, yield curve inversion preceded a stock market peak 6 times, with an average lead time of 7 months.


Source: Charlie Bilello 2014, Pension Partners

Currently, the yield curve is quite some distance away from inversion, although it is starting to show some signs of flattening, meaning we should watch this indicator closely.

However, overall, we see that most indicators show that we are still quite some distance away form a market peak, and that the current bull market still has room to run.

Recent stories

Age Pension and government benefits

When you retire, you may be eligible for government benefits such as the Age Pension or a concession card. The…

Read more

Super, death, and avoiding taxes

By Tony Kaye, Senior Personal Finance Writer, Vanguard Australia Having enough superannuation to enjoy a financially comfortable lifestyle in retirement…

Read more

Starting strong: Your 2021 Tech To Do list

In a year where simply keeping the doors open was a challenge for many businesses, finding the funds for tech…

Read more

Annuities

An annuity, also known as a lifetime or fixed-term pension, gives you a guaranteed income for a number of years.…

Read more

Budgeting 102: Sticking to your budget

Budgeting for a holiday or saving for a deposit? Even the best budget can unravel if the right tools are…

Read more